LXV Research

Charts, Ideas and the Euro

“There is nothing more deceptive than an obvious fact.” ― The Boscombe Valley Mystery by Arthur Conan Doyle

Gold vs. US 10 Year Treasury Real Yield

Source: Bloomberg

The above chart compares the year-over-year change in the US dollar price of gold versus the year-over-year change (inverted) in the real yield on US 10-year Treasury Securities. (The deflator used to calculate real yields is core inflation.)

Ever since the gold-bubble popped in 2011, the year-over-year change in its price has been negatively correlated with real 10-year yields. Intuitively, this makes sense given gold is a non-yielding asset and the lower the real yield on bonds the more attractive a non-yielding asset becomes on a relative basis.

Real yields can, of course, decline either due to nominal yields in bonds declining or by inflation picking up. In either case, if the relationship between gold prices and real yields holds, gold prices should move higher. With little seeming desire on the part of the Federal Reserve to jawbone rates higher — especially with a Twitter-happy president and global trade uncertainties rising — precious metals, other than their customary volatility, could be primed to move much higher. Our conviction will be increased if see gold take out its 2016 highs of around US dollars 1375 per troy ounce.

Thinking About the Euro

Try and go back to the start of the year and imagine:

(1) the trade dispute between the US and China escalating;

(2) global risk aversion — measured using the BNP Paribas Global Risk Premium Index — reaching levels last witnessed at the start of 2016;

(3) Italian bond yields blowing out;

(4) economic data coming out of Germany deteriorating;

(5) systemically important European banks, such as Deutsche Bank, crashing to new lows; and

(6) the positive carry (higher interest rate) for the US dollar over the euro sustaining.

Given the above scenario, most investors would want to be long the US dollar and short the Euro. And, indeed, positioning in futures markets suggests that investors are indeed long the greenback and short the euro. Yet, the US dollar is not moving higher. What gives?

EURUSD Curncy (EUR-USD X-RATE) 2019-06-07 18-06-14.jpg

The above is a monthly chart of the Euro US dollar cross. If we get follow through in the recent move higher in the euro by the end of this month, the probability is the euro strengthens from here at least to 1.20 and possibly higher. If, however, the recent move fails and the US dollar strengthens, then we may well get the doomer scenario of a US dollar that is too strong for the rest of the world to handle.

Our base case view is that a weakening greenback finally gets us the blow-off top or ‘market melt-up’ in US equity markets that many have been waiting for.

Watch the euro-US dollar cross and position yourself in stocks accordingly.

The ECB: Not Doing Enough to Prevent the Worst

At this week’s governing council meeting, the European Central Bank (ECB) left the deposit rate at -0.4 per cent and extended forward guidance into 2020, with rates expected “to remain at their present levels at least through the first half of 2020”.

The ECB also confirmed that the proceeds from maturing bonds in its portfolio will be reinvested to keep the stock of assets steady. Details of a third Targeted Longer-Term Refinancing Operation were also revealed: it will be held quarterly from September at interest rates as high as main refinancing operation rate (currently at 0 per cent) + 10 basis points and as low as the deposit rate + 10 basis points. The precise rate will depend on banks hitting their lending targets.

The ECB’s measures should support the European economy and potentially slow down the upward pressure on the euro from an increasingly dovish Fed. However, we do not think the ECB has gone far enough to address the challenges faced by its banks and a further deterioration in global trade activity. It might be that Mr Mario Draghi is passing the buck onto his yet to be named successor but we think the ECB may have at least one trick left up its sleeve: Open Monetary Transactions.

The Open Monetary Transactions (OMT) facility, established during the European crisis, has never been utilised. Currently, the ECB can only buy government bonds according to member states share of its capital. Under an OMT program, however, it would have the power to buy bonds of a specific member state if said member’s government accepts conditionality along the lines demanded by the International Monetary Fund for countries in its funding programs.

If the ECB eventually, albeit reluctantly, comes through with an OMT like programme or another measure to reduce the burden of negative interest rates on European banks, that too could push global stocks much higher.

Sharp Recovery in Healthcare Stocks

Take a look at the relative chart of the SPDR Health Care Select Sector ETF $XLV to the S&P 500 in the second panel below. After a more than four-moth period of drastic under performance by the healthcare sector, we have witnessed a sharp recovery in recent weeks.

We think healthcare stocks might be ripe ground for stock pickers.

XLV US Equity (Health Care Selec 2019-06-07 18-21-02

Some of the names we are tracking closely in the space are highlighted below.

Novocure $NCVR

Research and development company focused on developing cancer treatments with a market capitalisation of US dollars 5.3 billion. We recommend a small position here with a view of adding if it breaks to new highs, above US dollars 56.67.

NVCR US Equity (Novocure Ltd) VE 2019-06-07 18-44-57.jpg

AbbVie Inc $ABBV

Pharmaceutical behemoth $ABBV is starting to looking interesting to us at current levels. A move up US dollars 81.50 and we would be buyers. We recommend buy stops at the level.

ABBV US Equity (AbbVie Inc) VEEV 2019-06-07 18-50-15.jpg

Repligen Corp $RGEN

Massachusetts based $RGEN is engaged in the development and production of materials used in the manufacture of biological drugs ― substances made from a living organisms or its products and used in the prevention, diagnosis, or treatment of cancer and other diseases.

We are long here.

RGEN US Equity (Repligen Corp) V 2019-06-07 19-18-03.jpg

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

Charts and Comments

“During the 1970s, inflation expectations rose markedly because the Federal Reserve allowed actual inflation to ratchet up persistently in response to economic disruptions — a development that made it more difficult to stabilize both inflation and employment.” — Janet Yellen

Japanese Banks

On a price-to-book basis Japanese banks look cheap (top panel). Adjusting the price-to-book ratio for return on equity, Japanese banks are trading at their long-term average. (bottom panel).

TPNBNK Index (Tokyo Stock Exchan 2019-05-27 11-10-57.png

The Semiconductor to Software Flip

The below chart is the ratio of S&P Software GICS Level 3 Index to the Philadelphia Stock Exchange Semiconductors Index.

A potential trade to hedge out some risks from a further escalation in the trade dispute would be to be long software short semiconductors.

S5SOFT Index (S&P 500 Software I 2019-05-29 13-58-25.png

US REIT Spreads to 10 Year Treasury Yields

The top panel in the below chart is the absolute gross yield of the S&P US REITs Index and the bottom panel is the yield spread relative 10-year US Treasury Securities. REITs are not benefiting from the recent drop in bond yields but yield spreads are not showing any real signs of concern (unlike in 2016).

SREIUS Index (S&P USA REIT USD I 2019-05-31 13-35-13.jpg

If there is a deterioration in US economic activity yield spreads on REITs could spike. Alternatively, if inflation expectations pick up absolute yields could pick up.

An inflation neutral, US economic deterioration hedge could be long US 10-year Treasury Securities short US REITs. The negative carry, i.e. the higher yield on REITs means that the payout of coupons on the short side relative to the receipt of coupons on the long side, might make it a difficult trade to hold on to.

The Long Run S&P 500 to Silver Ratio

The below chart is the very long-run ratio of the S&P 500 Index to the dollar price of silver. (We did not use gold as the dollar was pegged to the barbarous relic for prolonged periods of time during the twentieth century.)

As the chart below suggests, we are getting close to bubble territory in terms of the value of the S&P 500 relative to silver. (Bubble territory being two-standard deviations above the long run average — the very top orthogonal line in the chart.)

SPX Index (S&P 500 Index) spx si 2019-05-31 14-17-08

The below chart, a bit messier one than the above, includes the year-over-year change in the US urban consumers price index (CPI) and the and the 4-year moving average of CPI.

SPX Index (S&P 500 Index) spx si 2019-05-31 14-48-16.jpg

The periods of benign or sharply declining inflation have generally been favourable for stocks relative to precious metals. While periods of sharply rising or persistently high rates of inflation have been

Members of the Federal Reserve have, in recent months, been talking up a monetary policy framework called average inflation targeting, which would entail accepting overshoots of the targeted two per cent price goal to make up for times when inflation was too low.

The concern we have, taking inspiration from the Janet Yellen quote above, is that a change in the monetary policy framework by the Fed causes “actual inflation to ratchet up persistently in response to economic disruptions”. The yield curve is sending a signal that the world will be unable to escape from the current deflationary / low-inflation trap that it has been stuck in. And the consensus view seems to be that trade wars are deflationary.

What if, however, the ongoing trade war between the US and China is about to cause an economic disruption that leads to a persistent ratcheting up of inflation?

Globalisation has been a deflationary force over the last three to four decades. The accession of China to the World Trade Organization (WTO), in particular, allowed 750 million workers, whose wages were estimated be as little as 10 percent to those of workers in developed markets, to enter the global trade system. The central bank policy response to the deflationary wave of globalisation and the abundant availability of low cost workers in China was that of lowering interest rates.

Low interest rates and juicy returns on investments made in China, and emerging markets in general, created a positive feedback loop.

Large US Corporations borrowed at low interest rates -> invested the capital in emerging markets and reduced capacities in developed markets -> developed market consumers benefited from lower prices -> central banks lowered interest rates -> rinse repeat.

Low interest rates beget lower interest rates. That is, until the capital being invested starts to get impaired and the cost to corporations is not just interest but also loss of principal. The victory of the Trump Administration in deterring the flow of capital into China by multinational corporations has been that, unlike previously, there is real concern now about loss of principal. And when corporations are sufficiently worried about loss of principal they do not invest.

Businesses, however, can only postpone investing for so long. A prolonged trade dispute is going to result in capital being invested in jurisdictions other than China. Executives and company boards, however, are likely to be sufficiently worried about other jurisdictions being targeted by the Trump Administration’s protectionist push. And so a portion, a significant one, of corporate investment budgets is going to be allocated to the US.

Labour markets in the US are tight. While capacities are not constrained, there is little slack. What if protectionism is the economic disruption that causes “inflation to ratchet up persistently”?

Trade Wars Revisited – Part II

“The secret to gaining the upper hand in a negotiation is to give the other side the illusion of control.” — Christopher Voss, former FBI hostage negotiator

Idea Updates

In our 2019 outlook piece issued on 7 January, we highlighted a number of emerging market ideas, the following are the idea we recommend closing out now:

1. Global X MSCI Argentina ETF $ARGT, which is up 11.61 per cent from market close on 7 January till yesterday’s close.

2. Ashmore Group $ASHM.LN, which is up 26.02 per cent from market close on 7 January till yesterday’s close in US dollar terms.

3. iShares MSCI Indonesia ETF $EIDO, which is down 9.66 per cent from market close on 7 January till yesterday’s close.

During the same period as the above ideas were open, the S&P 500 and MSCI ACWI indices have generated total returns of 11.56 and 9.07 per cent, respectively.

Trade Wars Revisited

More Bad News for Huawei

From the Financial Times:

Arm, which provides the underlying chip designs for the world’s smartphones as well as for many other types of semiconductors, has suspended business with the Chinese telecoms company due to the US clampdown on supplying it.

From the Nikkei Asian Review:

German chipmaker Infineon Technologies has suspended certain shipments to Huawei Technologies, three people familiar with the matter told the Nikkei Asian Review, in the first sign that Washington’s crackdown on the Chinese tech giant is beginning to choke off vital chip supplies from non-U. S. companies.

Huawei is going to need a lifeline sooner rather than later and the only person capable of providing it is President Trump. The Chinese company is likely to be central to an trade negotiations henceforth.

Is Oil Also Hostage to the Trade Dispute?

China’s three weaknesses just so happen to be three of the US’s strengths. One being semiconductors, which we have discussed previously, and the other two being oil and the US dollar.

China imports a lot of oil and produces very little of it. The US, propelled by the near miracle that is the Permian Basin, has become a net exporter of oil. A rising oil price hurts China, while it benefits the US and vice versa.

Given these dynamics, one is left considering the possibility that the US imposing economic sanctions on Iran and Venezuela, two oil exporting nations, and strong hints of warmongering in the Middle East by the Secretary of State Michael Pompeo is as much about Iran and Venezuela as it is about weaponizing oil against China.

If the US is indeed weaponizing oil then it is only a matter time before a controversy or conflict involving the Strait of Malacca hits the newswires. More than 90 percent of crude oil volumes flowing through the South China Sea transit through the Strait of Malacca, the shortest sea route between suppliers in Africa and the Persian Gulf and markets in Asia, making it one of the world’s primary oil transit chokepoints according to the US Energy Information Administration.

On the other hand, much like Huawei was stockpiling semiconductor inventories in case of an escalation in the US-China trade dispute, China, too, may have been stockpiling oil ahead of a possible escalation in the trade war. If indeed this has been the case, then some of the strength in the price of oil, particularly relative to other commodities, can be explained by the aggressive buying by China.

The top panel in the below chart are the monthly volumes of oil imported by China. The bottom panel is the year-over-year change in oil imports.

CCCIIQTL Index (China Customs Cr 2019-05-24 14-46-13.jpg

In the second panel in the chart above, we can see that the year-over-year increase in Chinese oil imports was the highest in December since May 2016. What explanation could there be for the aggressive Chinese buying other than stockpiling ahead of a potential escalation in the trade dispute? The price was certainly was not as attractive as it was in 2016 and the Chinese economy was not as strong as it was then either.

The Chinese response to a weaponizing of oil, we think, can come in three forms:

1. Scaling back of monthly imports in response to the tighter oil markets and higher price.

2. Finding a work around the sanctions on Venezuela and Iran and buying oil from them in return for renminbi or gold.

3. Urging Russia, its supposed ally and victim of US imposed sanctions, to break rank from OPEC and bring to an end the self-imposed production quotas in a bid to capture higher share of Chinese demand.

We think we have entered a volatile phase for the price of oil driven by the waxing and waning of push and pull forces in the trade dispute.

A More Coherent Trade Strategy by the Trump Administration

In May of last year in AIG, Robert E. Lighthizer, Made in China 2025, and the Semiconductors Bull Market we wrote (emphasis added):

Mr Lighthizer’s primary objectives with respect to US-Sino trade relations are (1) for China to open up its economy – by removing tariffs and ownership limits – for the benefit of Corporate America and (2) to put an end to Chinese practices that erode the competitive advantages enjoyed by US corporations – practices such as forcing technology transfer as a condition for market access.

Mr Lighthizer’s goals are ambitious. They will require time and patience from everyone – including President Trump, Chinese officials, US allies, and investors. For that, he will need to focus Mr Trump’s attention on China. He will not want the President continuing his thus far ad hoc approach to US trade policy. If NAFTA and other trade deals under negotiations with allies such as South Korea are dealt with swiftly, we would take that as a clear signal that Mr Lighthizer is in control of driving US trade policy.

China is clearly becoming the administrations’ singular focus when it comes to trade. Other trade disputes are being diffused just as hostilities towards China are escalating.

Last Friday it was announced that an agreement had been reached to lift the tariffs imposed by the US against Canadian and Mexican steel and aluminium imports in no later than two days. The tariffs, implemented last year by the Trump Administration had been a key impediment to Congressional ratification of the US-Mexico-Canada Agreement (USMCA), and made chances of passage of the agreement this year difficult.

In addition to lifting the import tariffs against Canada and Mexico, President Trump also has delayed for six months a decision on imposing tariffs on automobile and auto parts imports.

While the amendments to the USMCA and the postponements to the auto tariffs are positives within a sea of negativity (at least as it relates to capital markets), we do not consider the risk of auto tariffs being imposed to have diminished. Rather we see the postponement as a sign that President Trump will return to the matter with renewed intensity.

President Trump, since taking office, has barely wavered is his commitment to protectionism. In 2016 he campaigned on a protectionist agenda that he will want to claim he has delivered upon in his 2020 re-election bid. Moreover, with think he will feel is odds for success will be further strengthened by taking a hard line approach on trade rather than by negotiating agreements that would leave him open to criticism by both the trade hawks in his administration and by Democrats in Congress. Therefore we do not expect the President to pass up on the opportunity to be seen as being tough not only on China but also Japan and Germany, the nations most vulnerable to auto tariffs.

Trade Wars Revisited – Part I

“Uncertainty always creates doubt, and doubt creates fear.” — Oscar Munoz, Chief Executive Officer of United Airlines

“When the uncertain future becomes the past, the past in turn becomes uncertain.” — from Moth Smoke by Mohsin Hamid

We revisit the trade dispute between the US and China this week. We apologise in advance for the lengthy quotes from pieces we wrote last year but felt it necessary to provide context.

Note: We have split this week’s commentary in two parts as it runs quite long, the first part is below and the second will follow by Friday this week.

In December of last year in The Hawks Have Not Left the Building we wrote (emphasis added):

[W]e do not expect a breakthrough in negotiations to materialise during the next round of talks between Washington and Beijing before the suspension of the increase in tariffs lapses. As long as hawks such as Peter Navarro and Robert E. Lighthizer continue to have President Trump’s ear our view is unlikely to change. If, however, the dovish members of the Trump Administration, such as Treasury Secretary Steve Mnuchin and Director of the National Economic Council Lawrence Kudlow, begin to take control of proceedings we would become much more hopeful of a positive resolution to the trade dispute.

For now, we see the temporary agreement between the two sides as providing much needed short-term respite for China. More importantly, we see President Trump’s offer of a temporary ceasefire without President Xi offering any concessions on sensitive issues, such as industrial policy, state funded subsidies and intellectual property rights, to be a symptom of the short-termism that seemingly besets democratically elected leaders without exception. Had the US equity capital markets not faltered recently and / or the Republicans not lost control of the House of Representatives, it is unlikely, we think, that President Trump would have been as acquiescent.

The above quote provides the frame of reference from which the remainder of the analysis in this piece stems from.

Semiconductors: From Bad to Worse

The below chart compares the performance of the S&P 500 Index to that of the Philadelphia Semiconductor Index $SOX and the ADR of Taiwan Semiconductor Manufacturing Company $TSM over the course of the last month.

SPX Index (S&P 500 Index) Multi 2019-05-21 12-36-54.png

President Trump first tweeted about the trade negotiations with China falling apart on 5 May. Markets sold off a little in response to the tweet, semiconductor stocks sold off more. Then things got worse for semiconductor stocks, the US government issued an edict banning American suppliers from doing business with one of their biggest customers, Huawei Technologies Company, without the explicit approval of the US government. And then got even worse, the South China Morning reported that Huawei allegedly has been stockpiling a year’s worth of inventory out of fear of export ban being placed on US manufacturers. If true, US chipmakers’ earnings last year were much inflated.

Following the negative news, and striking a fear into markets that the Trump Administration was willing and able to inflict direct harm on US corporations in its bids to rein in China, government officials have come out suggesting that a handful of temporary exemptions may be granted. This would give some suppliers and customers of China’s telecom giant a 90-day reprieve from tough trade penalties.

From Fragile to “Antifragile”…

On 6 June 1967, Arab oil producing nations, to deter nations from supporting Israel in the six-day war, placed an embargo on oil exports to the US, UK and a number of other western nations. At the time the embargo was imposed, the UK was wholly dependent on foreign on oil resources and was, unsurprisingly, severely impacted by the embargo.

Between 1969 and 1970, vast oil reserves were discovered by the UK under the North Sea.

Then again in 1973, Organization of Arab Petroleum Exporting Countries proclaimed an oil embargo targeting the US, Canada, the UK, Netherlands, Japan and South Africa. The embargo was targeted at nations perceived as supporting Israel during the Yom Kippur War. The price of oil shot up from US dollars 3 per barrel to nearly US dollars 12 globally.

In 1973, the UK was still a net importer of oil and felt the sting from the Arab oil boycott. By 1979, on the back of the strength of the North Sea discovery, UK had propelled itself to become a net exporter of oil.

Just as the Arab oil embargoes spurred the UK’s discovery of North Sea Oil and eventual energy independence, the actions of the Trump Administration are almost certainly going to harden China’s resolve in developing a captive semiconductor industry.

President Xi Jinping has during his reign recounted the long and painful history of China surrendering to British imperialists in the nineteenth century, often referred to as the “century of humiliation”. Neither he nor his comrades at the Chinese Communist Party will want China’s dependence on US chipmakers to become a source of humiliation or an impediment to its growth ambitions. China has no choice but to invest in developing a captive semiconductor industry capable of competing with the best and brightest.

…But Achieving Antafragility Takes Time

From the original Arabian oil embargo, it took the UK a further eleven years to build up its oil production capabilities and to free itself from any future oil exporter hostilities.

China, too, will need time to develop its captive semiconductor industry. Huawei’s alleged hoarding of a year’s worth of supply of American manufactured inventory proves as much.

China’s semiconductor industry remains far behind its American and Korean counterparts in the manufacture of advanced processing chips. The challenges is further compounded with non-existent local production of the equipment that is required to design and fabricate advanced processing chips.

Semiconductor companies are now hostage to the vagaries of the American and Chinese trade dispute. Should some semblance of a trade agreement be miraculously salvaged semiconductor stocks will most likely rally and rally hard. If not, they might be in a long, painful ride.

The Huawei Question

Huawei, not for first time, is suffering at the hands of the US political establishment.

In January 2018, AT&T, pressured by Washington, walked away from a deal to sell the Huawei smartphone, the Mate 10, to customers in the United States just before the partnership was set to be unveiled. Verizon shortly followed suit.

Meng Wanzhou, CFO of Huawei and daughter of the company’s founder, was arrested on 1 December 2018 in Canada at the request of the US government for allegedly defrauding multiple financial institutions in breach of US-imposed bans on dealing with Iran.

In February 2019, US officials lobbied European authorities in banning Huawei from 5G network builds in Europe and called the Chinese company “duplicitous and deceitful”.

By forbidding US companies from trading with Huawei, one of China’s most prominent technology companies, without the government’s explicit permission, the Trump Administration is clearly sending a message. And the ban is not just limited to US companies, export controls also extend to non-US companies that sell any product in which US-origin technology comprises 25 per cent or more of the value. Given in the intertwined nature of semiconductor production, implying that Huawei is likely unable to replace US products it loses access to.

The question now is whether the Trump Administration goes for the kill or not. ZTE had to cease operations after being hit with US export controls, Huawei is likely to suffer same fate unless US officials make a u-turn. Given the heavy criticism President Trump received for rolling back sanctions on ZTE, it is unlikely that he would be as forgiving this time around with US elections next year unless he wants to revive the trade deal.

The fate of Huawei is now likely to signal the outcome of the trade deal:

1. Huawei survives and retains most of its pre-export glory and we get a “beautiful” trade deal.

2. Huawei survives but in a scaled back form and we get a patched up trade deal with both sides saving face.

3. Huawei fails and the trade deal is dead, or at least takes a very long-time to revive.

Two Ideas: Advanced Emissions Solutions & A Bitcoin Proxy

Panic causes tunnel vision. Calm acceptance of danger allows us to more easily assess the situation and see the options. — Simon Sinek

Advanced Emissions Solutions $ADES

In Environmental Concerns: Ideas on Long Side we discussed the lack of progress in reducing global emissions since the Paris Climate Agreement was signed by 190-plus countries in December 2015. At a high level we suggested Advanced Emissions Solutions as a potential long idea that could benefit from increased regulatory pressure to control emissions.

$ADES owns a 42.5 per cent stake in a joint venture with Goldman Sachs and Nexgen Refined Coal called Tinuum Group. Tinuum is awarded tax credits when it produces refined coal — coal that has been processed to reduce emissions when burned.

In the American Jobs Act of 2004 there was a provision to encourage the use of chemically treated coal to reduce the emissions from US power plants. To qualify for the refined coal tax credit, producers “must have a qualified professional engineer demonstrate that burning the refined coal results in a 20 per cent emissions reduction of nitrogen oxide and a 40 percent emissions reduction of either sulfur dioxide or mercury compared with the emissions that would result from burning feedstock coal”. The tax credit was designed to increase with inflation and was valued at US dollars 6.91 per short tonne produced in 2017 and US dollars 7.10 per short tonne in 2018. As an added bonus, some operating expenses incurred in running a refined coal facility are also tax deductible, making the tax credit’s effective value in 2018 as much as US dollars 9 a tonne.

The tax credit, as originally structured, was not easy for refined coal producers to take advantage of. The policy required producers to increase raw coal’s market value by 50 percent to qualify for the tax credit. This clause made cost-conscious utilities unwilling to buy refined coal.

A policy edit to the structure of the tax credit in 2008 by senators from Montana and Iowa, two coal producing states, however, removed the market value clause. The removal of this clause made it possible for refined coal producers to benefit from the tax credit even if they sold their product at a loss. This shift in policy incentivised the creation of Tinuum and other refined coal producers like it.

Tinuum financed the construction of facilities to produce refined coal situated next to coal-fired power plants. The window to construct these facilities closed in 2011 and the tax credits expire in ten years from commencement of operations. Republican Senator John Hoeven from North Dakota, also a coal producing state, has, however, introduced legislation to extend the tax credits by another ten years.

On average, each facility cost between US dollars 4 and 6 million to construct. Tinuum constructed 28 of them, making it the second largest operator in the refined coal space.

How does Tinuum benefit from the tax credit?

1. Power plants lease refined coal facilities from Tinuum at say a rate of US dollar 4 per tonne of refined coal (plus, at times, additional royalty commissions) — 42.5 per cent of which goes to $ADES

2. The refined coal facility is used to process feedstock coal and generate a tax credit at the prevailing inflation adjusted rate. Operating the refined coal facility costs power plant owners a further US dollars 3 per tonne.

3. Power plant owners receive the ~US dollars 7 per tonne in tax credits and at the same time the operating expenses incurred in running the refined coal facility and the lease payment to Tinuum are tax deductible. At a marginal tax rate of 21 per cent, the power plants tax bill is reduced by approximately US dollars 1.47 per tonne.

Tinuum presently has 20 of 28 refined coal facilities (representing 55 to 65 million tonnes of refined coal capacity) contracted to the owners of coal-fired power plants. In 2019, it has an opportunity to increase the utilisation of its idle facilities. A number of tax advantaged refined coal facilities that began operations in 2009 have seen or will see their tax advantaged status lapse during the year. One of the 20 operational facilities was contracted and brought online in January 2019. Management expects a further 12 millions tonnes of refined coal capacity to be contracted over the course of 2019.

Based on the 20 contracted facilities through 2021, when the tax credits expires, $ADES’s share of net refined coal related cash flows from Tinuum is estimated to be between US dollars 200 and 225 million. To put that into perspective the market capitalisation of $ADES is US dollars 248.8 million.

What other areas does Advanced Emissions Solutions operate in?

In December 2018, the company acquired ADA Carbon Solutions (ACS). ACS owns and operates an activated carbon manufacturing plant focused on “mitigating mercury emissions” from coal-fired power plants.

In its first full quarter since acquisition, ACS contributed US dollars 14.6 million in revenue to $ADES.

Management’s plan is to cross-sell ACS’s solutions to existing customers and also expand the mercury mitigation solutions services into other adjacent segments. One adjacent market they intend to target is the municipal water treatment market, a highly fragmented sector “comprised of many producers and re-sellers”. Management does not expect the entry into adjacent markets to require incremental investments to be made by the company.

Investment Thesis

$ADES currently trades at trailing twelve months earnings of 6.9 times and a dividend yield of 7.50 per cent with return on equity of 46 per cent.

Given the majority of the company’s market value is covered by its share of Tinuum’s contracted cash flows, we see $ADES as a cheap call option on (1) the potential increase in tax credit by another 10 years, (2) contracting of Tinuum’s remaining 8 refined coal facilities through 2021 and (3) the activated carbon segment.

A Bitcoin Proxy

Famed short-seller Jim Chanos, using his Twitter alias Diogenes (handle: @WallStCynic) recently tweeted:

“How the F is this bitcoin nonsense being resurrected again? Are people really this stupid?”

We do not know if buyers of bitcoin are being clever or not so clever. We do not know what is driving the buying. Maybe it is the employees of Lyft, Uber, Zoom or Pinterest, newly minted as millionaires, using a portion of their winnings to buy bitcoin. Or Chinese capital fearful of an imminent devaluation of the renminbi finding a way around capital controls by buying bitcoin. Or [insert here whatever is the narrative du jour for crypto-aficionados or crypto-sceptics].

What we do know is that it has been going up and it may go higher still.

Our aim here is not to argue for or against bitcoin. There are far smarter and far more informed people on both sides of the argument for any contribution we may have to make the debate to be value accretive even at the margin. Rather, we have found the process of buying and selling bitcoin somewhat cumbersome and want to suggest a proxy for those that may want to trade bitcoin and not necessarily own it.

The below is a normalised chart of bitcoin and The Bitcoin Group ($ADE.GY) starting 31 December 2016. The Bitcoin Group is a holding company focused on investing in businesses and technologies in the fields of cryptocurrency and blockchain. Presently, the holding company owns one asset: 100 per cent of the shares of Bitcoin Deutschland AG, the only German authorised trading platform for bitcoin.

XBTUSD Curncy (XBT-USD Cross Rat 2019-05-16 10-53-39.png

So if you want to trade bitcoin but find the whole process a bit cumbersome, The Bitcoin Group might be worth a look. As the chart seems to suggest, it has been a pretty good proxy to buying bitcoin, at least since the beginning of 2017.

Turkish Lira | HKD Peg

“We walked to the brink and we looked it in the face.” — John Foster Dulles, United States Secretary of State under President Dwight D. Eisenhower from 1953 to 1959

“People like me who were engaging in brinkmanship with the party economic bosses and the open dissidents who were being arrested were pursuing a common goal in different ways.” — Vaclav Klaus, Czech economist and politician who served as the second President of the Czech Republic from 2003 to 2013

Turkish Lira and Non-Resident Holdings

After a sharp decline between January and August last year and crossing the 7 handle, the Turkish lira rebounded by 15 per cent from September through December, following a massive interest rate hike by the Turkish central bank. The currency, following a period of relative calm for during the first two months of 2019, has once again started dropping like a stone, although not as precipitously as last year.

The recent decline in the lira has been triggered by an economy stuck in stagflation and heightened political instability, which, of course, has been par for the course under President Recep Tayyip Erdoğan. The currency came under pressure this week after fresh elections were announced for the city of Istanbul on the demands of the AK Party, Turkey’s ruling party, which narrowly lost control of the city in municipal elections last March.

Nonresident investors in Turkish capital markets have responded to the economic and political uncertainties by dumping their holdings of domestic bonds and equities. Net outflows of nonresident portfolio investment in local currency assets amounted to US dollars 1.4 billion in March and April as foreign investors pulled capital out of both the domestic bond and equity markets. Nonresidents now hold only 12 per cent of domestic public debt, down from over 20 per cent in 2018.

The chart below compares the Turkish lira-US dollar currency pair (inverted) to the sum of the nonresident holdings of the domestic bond and equity markets. As can be seen from the chart, the currency pair has been tightly correlated with the level of nonresident holdings of domestic assets.

TRY / USD (Inverted) vs. Non-Resident Domestic Bond and Equity Holdings

TRY NonResidential Portfolio Investments.png Source: Bloomberg

With limited room for the nonresident holdings to fall much further — assuming that Turkey is not dropped from global equity and bond indices, events that would force passive investors to also sell down Turkish assets — we would be tempted to go long the lira at current levels, were it not for the unpredictability of Turkey’s leadership.

Hong Kong Dollar Peg

From The Wall Street Journal on 25 April 2019:

Kyle Bass, the often-bearish hedge-fund manager who won big during the global financial crisis, has trained his sights anew on the Hong Kong dollar.

Mr. Bass’s Dallas-based Hayman Capital Management LP published its first investor letter in three years this week, titled “The Quiet Panic in Hong Kong.” Mr. Bass gained publicity a decade ago for his bearish bets against securities tied to the U.S. housing market.

The investor letter, which was viewed by The Wall Street Journal, argues that a combination of rapid growth in floating-rate mortgages, the gap between local and U.S. short-term interest rates, and mounting geopolitical tensions between the U.S. and China put Hong Kong’s currency arrangement at risk of breaking.

“Hong Kong currently sits atop one of the largest financial time bombs in history,” Mr. Bass said in the letter. He said the size and leverage of the city’s banking system made it similar to Iceland, Cyprus and Ireland before their financial crises.

The Asian Financial Crisis originated on 2 July 1997, the day after the sovereignty of Hong Kong was transferred from the United Kingdom to China, with the devaluation of the Thai baht.

The crisis came to be defined by the speculative bets by western hedge fund managers against the many dollar-pegged currencies of South East Asia and precipitating the near collapse of famed US hedge fund Long Term Capital Management.

Hong Kong, too, was embroiled in the crisis; however, unlike Thailand, South Korea and Indonesia, the authorities in Hong Kong chose asset price deflation and economic pain over letting go of their currency peg. The Hong Kong Monetary Authority (HKMA) at one point in 1997 raised overnight interest rates to over 200 per cent, testing speculators’ wherewithal in holding on to their shorts against the currency and in the local stock market. As a corollary of the HKMA’s actions to deter speculators, GDP declined by 5 per cent in 1998 compared to growth of 5.3 per cent in 1997, unemployment reached 6.4 per cent and real estate prices in city-state more than halved.

The spillover effects of a collapsing real estate market were particularly damaging for Hong Kong’s economy. As property values fell, banks curtailed lending and land sales, a significant source of government revenues, fell off a cliff, sending the government’s fiscal revenues plunging. The government, accustomed to running a fiscal surplus, experienced a fiscal deficit of approximately US dollars 3 billion in 1998/99.

The HKMA ended up spending around US dollars 15 billion to fight off short sellers, including buying up stocks and borrowing all the stocks available in the market.

Hong Kong’s experience and the measures taken by its authorities in defending the currency peg is a testament to the pain the city-state is willing to endure to defend the Hong Kong dollar’s peg to the US dollar. Anyone seeking to duke it out with the HKMA should expect a long and arduous battle with little hope of victory in the near term.

The political will to hold on to the dollar-peg is strong. What about the economic reality? One could fairly argue that the political will to defend the peg was also there in Thailand, South Korea and Indonesia but they failed where Hong Kong succeeded. We are of the opinion that the economic reality in favour of the peg remaining are just as strong as the political will.

We quote from the speech given by Mr Norman T. L. Chan, the then Chief Executive Officer of the HKMA, at the Oxford University in 1999 on the lessons from the Asian Financial Crisis (emphasis added):

The banking systems were inadequately supervised and were prone to incurring excessive risks by borrowing short-term funds to finance long-term lending to projects the viability of which was doubtful. Moreover, the corporate sectors of many Asian economies were over-stretching themselves by engaging in risky or unproductive investments. To a varying degree, both the banks and corporates were taking excessive currency risks by borrowing in foreign currencies, which had a much lower interest costs than domestic currencies, to fund projects which could only generate income, if any at all, in domestic currencies. The implicit guarantee of exchange rate stability provided by the governments weakened the alertness to the risks arising from currency and maturity mismatches. As the amounts of international capital flows increased phenomenally in the last few years, disaster struck when the bubble burst.

Excessive currency risk, to paraphrase the words of Mr Chan, were being taken by banks and corporations by borrowing in foreign currencies due to interest rates being lower offshore than onshore. Today, the interest rates in Hong Kong are lower than interest rates in the US. There is no structural reason for banks and corporations to borrow in hard currency and take on excessive currency risks. Implying that one of the conditions that made shorting South East Asian currencies such an asymmetric bet during the Asian Financial Crisis absent for the Hong Kong dollar today.

Short sellers may argue that what makes shorting the Hong Kong dollar particularly attractive is the positive carry i.e. they earn the interest differential between overnight rates in Hong Kong and LIBOR when they short the Hong Kong dollar. Meaning that there is little downside to putting on the trade. This is true till it ceases to be true. If speculators begin to the pile into the trade, overnight rates in Hong Kong will ultimately converge with LIBOR and said free lunch will cease to exist. Should the size of the trade get sufficiently large, the positive carry could even turn into negative carry.

Next, we compare Hong Kong’s monetary base — as defined by the HKMA as consisting as the sum of the certificates of indebtedness outstanding, government notes and coins in circulation, closing aggregate balance, and outstanding exchange fund bills and notes — to the office level of foreign currency reserves held by the HKMA.

Hong Kong Official Foreign Currency Reserves vs. Monetary Base

HKD Monetary Base.png

Source: Hong Kong Monetary Authority

As can be seen in the above chart, the level of foreign reserves held by the HKMA is more than double the city-state’s entire monetary base i.e. the HKMA has sufficient reserves for the entire monetary base to head for the exits twice over. During the Asian Financial Crisis, the HKMA used US dollars 15 billion to fight short-sellers. Today it has more than US dollars 200 billion to fight them with.

We do not have the wherewithal or the appetite for a fight with the HKMA and neither should you!

Definitions

Certificate of Indebtedness

When note-issuing banks in Hong Kong issue banknotes, they are required by law to purchase Certificates of Indebtedness, which serve as backing for the banknotes issued, by submitting an equivalent amount of US dollars at the rate of HK$7.80 to one US dollar to the HKMA for the account of the Exchange Fund.

The Hong Kong dollar banknotes are therefore fully backed by US dollars held by the Exchange Fund. Conversely, when Hong Kong dollar banknotes are withdrawn from circulation, Certificates of Indebtedness are redeemed and the note-issuing banks receive an equivalent amount of US dollars from the Exchange Fund.

Closing Aggregate Balance

Aggregate balance is the sum of balances in the clearing accounts and reserve accounts maintained by commercial banks with the central bank. In Hong Kong, this refers to the sum of the balances in the clearing accounts maintained by the banks with the HKMA for settling interbank payments and payments between banks and the HKMA. The aggregate balance represents the level of interbank liquidity.

Exchange Fund Bills and Notes

Exchange Fund Bills and Notes are Hong Kong dollar debt securities issued by the HKMA. They constitute direct, unsecured, unconditional and general obligations of the Hong Kong Special Administrative Region Government for the account of the Exchange Fund and have the same status as all other unsecured debt of the Government. The Bills and Notes are for the account of and payable from the Exchange Fund.

The Exchange Fund Bills and Notes Issuance Programme ensures the supply of a significant amount of high-quality Hong Kong dollar debt paper, which can be employed as trading, investment and hedging instruments. Authorized Institutions that maintain Hong Kong dollar clearing accounts with the HKMA may use their holdings of Exchange Fund papers to borrow Hong Kong dollars overnight from the Discount Window. Active primary and secondary markets for Exchange Fund Bills and Notes has facilitated the development of a sophisticated Hong Kong dollar debt market.

Source: Hong Kong Monetary Authority

Notes: To read more about the Hong Kong currency board click here

European Growth Surprise

“Commerce flourishes by circumstances, precarious, transitory, contingent, almost as the winds and waves that bring it to our shores.” — Charles Caleb Colton

“Politicians know that structural reforms – to increase competition, foster innovation, and drive institutional change – are the way to tackle structural impediments to growth. But they know that while the pain from reform is immediate, gains are typically delayed and their beneficiaries uncertain.” — Raghuram Rajan

Following four quarters of negative growth surprises, the European economy positively surprised for the first quarter of 2019. Based on preliminary data, the Euro Area’s GDP grew 1.2 year-over-year and 0.4 per cent quarter-over-quarter. Quarter-over-growth was up from the 0.2 per cent recorded in fourth quarter last year and ahead of the 0.2 per cent growth anticipated by the ECB as recently as March. As an added boost, Italy emerged from its third recession in a decade.

In March, the ECB revised down its GDP growth projection for this year to 1.1 per cent from 1.7 per cent last December. If forthcoming data confirm the gradual improvement in the economy, the ECB may well need to revise its GDP growth projections in June. The performance of the European economy during the last quarter may yet prove to be fleeting given transitory effects.

Automotive sales declined month-over-month in each of last four months of 2018 — plunging 11.4 quarter-over-quarter, on a seasonally adjusted basing, during the fourth quarter — triggered by the introduction of tougher emission standards by European regulatory authorities. The new standards have been drafted with the intent giving consumers a more realistic picture of fuel economy by compelling automakers to test vehicles in conditions more representative of real-world conditions. The transition to the new regulatory regime upset the apple cart, automakers struggled to complete testing and certification in a timely manner — impacting production and leading wide-scale inventory shortages.

More than half of automakers’ production losses were recouped in first quarter of this year.

Part of the slowdown in 2018 was also driven by the draw down of inventories, which led to weakness in intermediate goods production following a significant upcycle in 2017. The downward inventory trend was partly reversed in the first of quarter of this year and the correction may still have a few more months to run.

Construction activity during the first quarter of this year may also have been exaggerated. A relatively mild winter, particularly in February and March, boosted construction activity. In February, construction output jumped by 3 per cent month-over-month. (March data is not yet available.)

The non-transitory positives were accelerating wages, healthy levels of job creation and robust consumer spending. Fixed investment by business also continued to expand at a healthy clip driven by high levels of capacity utilisation — Italy is the exception of course, the economy continues to operate below levels recorded in 2008.

There were no signs of a pick-up in exports from Euro Area, based on January and February data. Global trade, however, is no longer declining and may not be headwind to growth in 2019, especially if the US and China reach some sort of agreement in their trade dispute in the near term and Europe avoids an escalation of trade tensions with the US.

The positive growth for the first quarter have been reflected in an uptick in European money supply M2 — defined as currency in circulation plus overnight deposits plus deposits with an agreed maturity up to 2 years plus deposits redeemable at a period of notice up to 3 months.

European M2 growing at an annual pace of 5 per cent, outside a recession, has in recent years translated into the economy expanding between 1 and 2 per cent. With M2 growth still range bound, we see limited capacity for the European economic growth to further surprise to the upside forth rest of 2019 barring a remarkable recovery in global trade or in global auto demand.

EHGDEUY Index (Eurozone Real GDP 2019-05-03 06-44-13

Turning to equity markets and with the MSCI Europe Total Return Index up almost 14 per cent year-to-date in US dollar terms, the question is whether a broad exposure to European equity markets warranted?

The chart below compares the MSCI Europe Index to the year-over-year growth in European money supply M1 advanced by 12 month. (M1 is the ECB’s narrow measure of money supply which comprises only currency in circulation plus overnight deposits i.e. highly liquid money that can be spent immediately.)

Based on the chart below the European equity markets may already priced in the good news.

MXEU Index (MSCI Europe Index) E 2019-05-03 06-25-31

Another time series we chart against the MSCI Europe Index is the ratio of the narrow measure of money supply M1 to the broader measure of money supply M2, once again advanced by twelve months. Based on the comparison of the two time series, the historical relationship suggests that there may yet be upside in Europe still.

The historical relationship makes sense, as M1 expanding at a faster rate than M2 — the composition of money supply shifting from a less liquid form to a more liquid one — was a leading indicator for increased capital expenditures. This relationship, in our opinion, is not as robust as it used to be as the ECB has eliminated the opportunity cost for individuals and businesses in holding cash in demand deposits, rather than placing it in higher yielding time deposits. Two-year deposits yield as little as 3 basis points today while businesses could earn as much 120 basis points prior to the Global Financial Crisis and as much as 300 basis points during the Eurozone crisis.

MXEU Index (MSCI Europe Index) E 2019-05-03 06-31-54

Exposure to Euro Area equities should be based on bottom stock selection to identify value opportunities, in our opinion. While we think broad based equity exposure to non-emerging Europe should be avoided at this stage.

US Infrastructure

“We need to build roads, bridges, airports, locks, dams, and rail that work for this century — not the last one. And let’s not forget about updating our energy grid, repairing and replacing our water infrastructure and sewers, and making sure all Americans have access to broadband.” — Amy Klobuchar

“We can only create good jobs if we make smarter investments in infrastructure and do more to support small businesses, not stiff them.” — Michael Bloomberg

The condition of roads, bridges, schools, water treatment plants, and other physical assets greatly influences an economy’s ability to function and grow. For an economy to realise its full potential it requires well-maintained roads, railroads, airports, and ports to facilitate commerce.

Infrastructure in the United States, unfortunately, is crumbling — unsurprising when non-defense gross government investment (federal, state, and local) has largely been in decline since the 1960’s, falling from above 4 per cent of GDP to about 2.3 per cent in 2017.

In its most recent report card on the condition of America’s infrastructure, the American Society of Civil Engineers (ASCE) gave U.S. infrastructure a D+ or “poor” rating. The ASCE argues that the US can no longer afford to delay investing in its critical infrastructure systems. Henry Petroski in his book The Road Taken: The History and Future of America’s Infrastructure explains that the delays caused by traffic congestion alone cost the economy over US dollar 120 billion per year.

According to the ASCE’s estimates, the cost of bringing America’s infrastructure to a state of good repair (a grade of B) by 2025 is US dollars 4.6 trillion, of which only little more than half has been committed. Improving roads and bridges alone requires more than US dollars one trillion more than the amount allocated.

Infrastructure investment has received renewed interest in Washington following the mid-term elections last year, we have seen President Trump, Senators and some Members of Congress all discussing the benefits of upgrading the US’s infrastructure in the recent past.

Amy Klobuchar, the Senator from Minnesota, one of the Democrats from the crowded field of Democrats angling to take on President Donald Trump in 2020, has proposed a US dollars 1 trillion infrastructure investment package. President Trump in his 2020 budget request to Congress has renewed call for a US dollars 1 trillion infrastructure plan.

The consistency of the message on infrastructure spending from both the Democrats and Republicans is unsurprising.

There is a general consensus amongst economists and analysts that spending on infrastructure has a fiscal multiplier effect much larger than the typical government spending multiplier. A study conducted by economists at the Federal Reserve Bank of San Francisco in 2012 on the impact of unexpected infrastructure grants on state GDPs (GSPs) since 1990 found that, on average, each dollar of infrastructure spending increases the GSP by at least two dollars. While a University of Maryland study conducted in 2014 found that infrastructure investments added as much as US dollars 3 to GDP growth for every dollar spent.

Investment Perspective

The unmet infrastructure investment needs of the US and the growing political consensus around upgrading the nation’s infrastructure, we think, will be a tailwind for companies that can cater to the demand created by such spending.

The most obvious way to play the US infrastructure investment theme is through the Global X US Infrastructure Development ETF $PAVE.

PAVE US Equity (Global X US Infr 2019-04-26 11-19-26.jpg

While we think a generalised exposure through an ETF may work well over a prolonged period. There a number of direct plays that we think may be superior in the nearer term — once there is more clarity or momentum in pushing through infrastructure spending programs in Washington.

On the telecommunications and technology upgrade front we think Clearfield Inc. and A10 Networks Inc. are potential long ideas.

The next generation of cell phone and wireless service will need large scale investments in “small cell” wireless nodes, which are expected to replace traditional cell towers. Moreover, more than 19 million people living in rural America do not have access to broadband and investment needs to go into eliminating this so called “broadband gap”.

Clearfield Inc. $CLFD manufactures telecommunication equipment. The company designs accessories, cassettes, connectors, assemblies, panels, and other related products for various applications.

CLFD US Equity (Clearfield Inc) 2019-04-26 11-25-21

A10 Networks Inc. $ATEN provides computer networking products and security solutions. The Company offers controller, firewall, hardware appliances, protection systems, and other networking products.

ATEN US Equity (A10 Networks Inc 2019-04-26 11-30-19.jpg

On the construction and construction materials side we Vulcan Materials Co., Construction Partners Inc. and Quanta Services Inc.

Vulcan Materials Co.$VMC produces construction aggregates. The Company’s principal product lines are aggregates, asphalt mix and concrete, and cement.

VMC US Equity (Vulcan Materials 2019-04-26 11-39-16.jpg

Quanta Services, Inc. $PWR provides specialized contracting services to electric utilities, telecommunication, cable television operators, and governmental entities. The Company also installs transportation control and lighting systems and provides specialty electric power and communication services for industrial and commercial customers.

PWR US Equity (Quanta Services I 2019-04-26 11-42-45.jpg

Construction Partners, Inc. $ROAD provides infrastructure construction services. The Company offers services to public and private infrastructure projects includes highways, roads, bridges, airports, and commercial and residential sites. Construction Partners serves customers in the United States.

ROAD US Equity (Construction Par 2019-04-26 11-42-12

Lighten Up On Semiconductors

“The good times of today, are the sad thoughts of tomorrow.” — Bob Marley

Chinese Economic Data

The Chinese economy grew at 6.4 per cent year-over-year during the first quarter of 2019, matching the economy’s growth during the fourth quarter of last year but below the 6.6 per cent growth achieved for the full year during 2018. Growth came in slightly higher than consensus expectations and appears to have been buoyed by strong credit growth — system-wide financing was up 10.7 per cent year-over during March, led by an acceleration in lending by Chinese financial institutions. Total loans extended by financial institutions increased by 13.7 per cent year-over-year in March to reach its highest rate since June 2016.

CNLNTTLY Index (China Total Loan 2019-04-18 13-38-21.png

There was a sharp recovery in the Chinese industrial sector during March, industrial value added surged to 8.5 per cent year-over-year, up from 5.7 per cent in February. Part of this growth can probably be attributed to the Chinese New Year falling in early February this year versus being in late February last year — factories are likely to have only reached stable production into March in 2018. We will look to April data upon its release for further clarity.

CHVAIOY Index (China Value Added 2019-04-18 13-54-41.png

Despite the above caveat, some of the notable metrics on the industrial side include:

Steel, glass and cement production were up 10, 8 and 22 per cent year-over-year in March, respectively. The strong growth in production figures of construction materials reconciles with the 12 and 18 per cent year-over-year increases in property investment and construction starts, respectively. The growth in construction starts was matched by the 18 per cent year-over-year growth in mortgage lending.

Smartphone, automotive and semiconductor production dropped by 7, 3 and 2 per cent, respectively.

The bad news for semiconductors was not limited to production. Chinese imports of diodes and semiconductors during March declined by 11.8 and 12.7 percent year-over-year in value and volume terms, respectively. For the first quarter imports are down 9.6 and 14.7 per cent year-over-year in value and volume terms, respectively.

The decline in semiconductors may prove to be a red herring. It is altogether possible that Chinese authorities are eager to limit semiconductor imports up until a trade deal has been struck with the United States. Unleashing a flurry of semiconductors orders from to help close the bilateral trade deficit, upon signing of a trade pact. If this indeed is the case, it would go someway towards explaining the discrepancy between the strength in China’s Purchasing Manager’s Index and the weakness in Korean and Taiwanese exports to China.

Given the softness in Chinese semiconductor imports, our conviction in our earlier call of shorting Taiwanese semiconductor companies as a hedge for portfolios positioned for an amicable resolution to the US-China trade dispute is strengthened. Further, we think shorting Taiwanese semiconductor is one of those rare situations of “heads I win and tails I do not lose” — under an amicable trade resolution, marginal Chinese demand shifts from Taiwan to the US, while under a deterioration of trade relations the risk of Taiwan being annexed increases markedly.

Away from semiconductors, given the pick up in Chinese industrial activity and credit impulse and the robustness of the property market, we reiterate our call for fixed-income investors to close out long positions in long-dated Chinese government bonds.

Lighten Up On Semiconductors

Despite the slowdown in Chinese semiconductor imports, the market has bid up semiconductor stocks to record highs. The Philadelphia Stock Exchange Semiconductors Index is up 35.4 per cent year-to-date versus 16.4 per cent for the S&P 500 Index.

The index has been buoyed by recent announcements from Intel, Apple and Qualcomm.

Apple and Qualcomm announced that the two parties agreed to dismiss all litigation between them world-wide and signed a new licensing agreement, which brings to an end the long-running legal battle over how royalties are collected on innovations in smartphone technology. Qualcomm said the agreement will add about US dollars 2 in annual earnings per share. Qualcomm’s stock jumped 23 per cent on the news.

Following the announcement from Apple and Qualcomm, Intel announced that is was withdrawing plans to make modem chips for 5G smartphones. Investor’s cheered the decision, pushing Intel’s stock to 19-year highs.

Such positive news from two of the five largest constituents of the Philadelphia Stock Exchange Semiconductors Index is a pretty high bar to set for good news to clear in the near term. And the market’s reaction function to news about the on going US-China trade negotiations exhibiting more than a tinge of buying the rumour, we are concerned that an eventual agreement will close the loop by being a sell the news event.

We think it is as a good time as any to lighten allocations in the semiconductor space.

Inflationary Pressures

From The Beige Book issued 17 April 2019 (emphasis added):

Employment continued to increase nationwide, with nine Districts reporting modest or moderate growth and the other three reporting slight growth. While contacts reported gains across a variety of industries, employment increases were most highly concentrated in high-skilled jobs. However, labor markets remained tight, restraining the rate of growth. A majority of Districts cited shortages of skilled laborers, most commonly in manufacturing and construction. Contacts also reported some difficulties finding qualified workers for technical and professional positions. Many Districts reported that firms have offered perks such as bonuses and expanded benefits packages in order to attract and retain employees. This tight labor market also led to continued wage pressures, as most Districts reported moderate wage growth. Wages for both skilled and unskilled positions generally grew at about the same pace as earlier this year.

The below chart compares the National Federation of Independent Business (NFIB) time series on businesses reporting on job openings hard-to-fill to the growth in US nonfarm unit labour costs on a year-over-year basis. (The unit labour costs time series is lagged by a year, as it takes time from businesses realising that jobs are hard-to-fill to be willing to pay higher.)

COSYNFRM Index (US Unit Labor Co 2019-04-18 16-35-16.png

As can be seen from the chart above, the disconnect between the two time series today is quite large. If we take the commentary in The Beige Book at face value, there should be some convergence between the two series, with unit labour costs rising. If that transpires, we may finally see a sustainable pick up in inflationary pressures in the US, which may also mark the cyclical top in corporate profit margins.

The acceptance for and popularity of socialism driven in part by a decade of returns flowing to asset owners at the expense of labour providers, may just be coming at very moment the structural forces are set to move in favour of labour.

Market Puzzles

“People who work crossword puzzles know that if they stop making progress, they should put the puzzle down for a while.” — Marilyn vos Savant, listed in the Guinness Book of World Records under “Highest IQ” from 1986 to 1989 and entered the Guinness Book of World Records Hall of Fame in 1988.

English engraver and cartographer John Spilsbury is said to have invented jigsaw puzzles during the second half of the eighteenth century. He was concerned, allegedly, with promoting a new way of teaching geography. We suspect, he is unlikely to have envisioned how his invention would evolve to become a form of entertainment for the masses.

Jigsaw puzzles as a form of entertainment for adults emerged around the start of the twentieth century and by 1908 a full-blown jigsaw craze had started in the United States which quickly spread across the Atlantic to Britain, and then around the world. The trend is said to have started in Newport, before spreading to New York, Boston and abroad. Adults across all rungs, except the very lowest, of society were sucked into the craze and puzzles became a primary form of entertainment in high society house parties in Newport and other country retreats. Although the fever eventually subsided, puzzles remained a regular source of adult amusement for the next two decades.

The onset of the Great Depression in 1929 coincided with a resurgence in the popularity of jigsaw puzzles. Sales are estimated to have peaked in early 1933 at a remarkable 10 million units per week. Puzzles, it seems, offered an escape from the financial woes of the times, as well as providing a sense of accomplishment during a time when jobs were hard to come by.

For us, price charts and evolving relationships between macroeconomic variables are the pieces of a puzzle we are continuously striving to put together in order to have a clearer picture of the market.

In this week’s piece we run through some charts and macroeconomic relationships that dominate our thinking at the moment.

US Credit Flows and the US Dollar

Prior to the Global Financial Crisis, the year-over-year change in the broad measure of US money supply, M2, was a very good proxy for trading the US dollar. Essentially, if the expectations were of credit to flow at a faster clip in the US economy, it paid to be long the dollar. If one the other hand, if the expectations were of credit conditions to tighten, it was better to be short the dollar.

The chart below plots an adjusted measure of year-of-year growth in broad US money supply, with the US dollar index, $DXY. The relationship worked swimmingly till the run up to the financial crisis. Following the crisis, there has been a disconnect that has largely remained.

DXYM2 wo ER

What we think changed following the crisis is broad money supply no longer being a suitable proxy for the flow of credit in the US economy. And the source of that change was the Fed’s large scale asset purchases in response to the financial crisis. The purchases were funded through the increase in reserve balances in excess of regulatory reserve minimum requirements. Essentially, the growth in the broad money supply following the crisis was not translating into increases in the flow of credit because banks were parking money with the Fed.

The below chart further adjusts the money supply time series for increases and decreases in the supply of excess reserves — the year-over-year growth (decline) in excess reserves is deducted (added) from (to) M2 to obtain a better estimate of the flow of credit in the US economy.

DXYM2 w ER

We think this chart captures the recent resilience of the US dollar. Although credit in its traditional forms, as depicted in the first chart, has remained tight, the draw down of excess reserves due to quantitative tightening has supported broad money supply growth. This in turn has been, we think, supportive of the greenback.

Given this adjusted metric, we can now hypothesise on the ways forward for the dollar.

For now, given the Fed’s intention to stop shrinking its balance sheet from September onward, the dollar’s continued resilience will hinge upon other sources of growth in credit. The reemergence of President Trump’s infrastructure bill could be one such source — should it materialise, it is likely to draw capital to the US from the rest of the world and push the dollar to new highs. Till it transpires, however, the risk-to-reward ratio is not in favour of dollar bulls.

Large scale infrastructure spending in the US may also be the scenario under which commodities and the dollar strengthen in sync while US Treasuries do poorly.

Emerging Markets

Given the crackdown on shadow banking in China, the waxing and waning of Chinese shadow financing is no longer a primary driver of emerging markets.

MXEF Index (MSCI Emerging Market 2019-04-11 15-37-39.png

Standalone and relative to the S&P 500, emerging markets do not look bearish at an aggregate level.

MXEF Index (MSCI Emerging Market 2019-04-11 15-38-38

Russia is increasingly looking like the market to own in emerging markets. (The bottom panel is the MSCI Russia Index relative to the MSCI Emerging Markets Index.)

MXRU Index (MSCI Russia Index) R 2019-04-11 15-55-30.png

The gains in oil this year, however, have not fully been reflected in the Russian equity market’s performance. (The bottom panel is the MSCI Russia Index relative to WTI crude.)

MXRU Index (MSCI Russia Index) R 2019-04-11 16-54-28.png

While those long $ARGT should be looking to sell into Argentina’s inclusion into the MSCI Emerging Markets Index at the end of May.

ARGT US Equity (Global X MSCI Ar 2019-04-11 15-56-57.png

London-based emerging markets asset manager, Ashmore Group $ASHM.LN, has had a great run even relative to the emerging markets index. It is up 30.3% year-to-date in US dollar terms.

ASHM LN Equity (Ashmore Group PL 2019-04-11 16-02-52.png

Long Term Yields in China and the US

The below chart compares China’s purchasing managers’s index (advanced by three months) to the yield on 10 year Chinese government bonds.

Despite China’s inclusion into global bond benchmarks and record foreign inflows, yields are no longer moving lower suggesting that long-term yields in China may have bottomed — the recent pickup in PMI indicates as much as well. If yields have bottomed, or close to it, it is also likely that economic activity in China, too, is set to pick up.

GCNY10YR Index (China Govt Bond 2019-04-11 16-17-13

Long-term yields in China have over the last decade largely mirrored movements of long term yields in the US. If Chinese yields have bottomed and economic activity is picking up, we would not be surprised to see US long-term yields move higher from here as well.

GCNY10YR Index (China Govt Bond 2019-04-11 16-13-38